Benefits of a Tax-Deferred UPREIT Transaction

For physicians selling appreciated medical office buildings, capital gains taxes can consume 25-40% or more of sale proceeds. While 1031 exchanges offer tax deferral, they require identifying and purchasing replacement property within strict timeframes. UPREIT transactions provide a compelling alternative: complete tax deferral without replacement property requirements, while gaining professional management, diversification, and liquidity.

Despite these advantages, UPREITs remain underutilized and misunderstood by many physician property owners. This article explains how UPREIT transactions work, their benefits and considerations, and when they make sense as an exit strategy.

What Is a UPREIT?

UPREIT stands for "Umbrella Partnership Real Estate Investment Trust"—a structure that allows property owners to contribute real estate to a REIT's operating partnership in exchange for partnership units, deferring capital gains taxes indefinitely.

The Basic Structure

Traditional Property Sale:

• Physician sells property for cash
• Pays capital gains tax immediately (23.8% federal + state)
• Receives net proceeds after tax

UPREIT Transaction:

• Physician contributes property to REIT's operating partnership
• Receives operating partnership (OP) units equal to property value
• No capital gains tax at contribution
• OP units generate quarterly distributions like REIT dividends
• Can hold units indefinitely, only paying tax when units are sold or exchanged for REIT shares
• If held until death, heirs receive step-up in basis, eliminating capital gains entirely

How It Works: Step-by-Step

Step 1: REIT Acquisition

Healthcare-focused REIT identifies physician-owned medical office building for acquisition. REIT offers to acquire property via UPREIT structure.

Step 2: Property Valuation

Independent appraisal establishes fair market value. This determines the number of OP units physician receives (value of property ÷ value per OP unit = units received).

Step 3: Contribution

Physician contributes property to REIT's operating partnership in tax-free exchange for OP units under IRC Section 721. Physician's basis in property carries over to OP units.

Step 4: Ongoing Ownership

Physician holds OP units, receiving quarterly distributions. REIT manages property professionally. Physician participates in appreciation of entire REIT portfolio, not just contributed property.

Step 5: Future Liquidity Options

• Hold Indefinitely: Continue receiving distributions; hold until death for basis step-up
• Exchange for REIT Shares: Typically after 1-year lock-up, can exchange OP units for publicly-traded REIT shares (taxable event)
• Sell Units: Trigger capital gains tax and receive cash proceeds

Key Benefits of UPREIT Transactions

1. Complete Tax Deferral Without Replacement Property

The Advantage: Unlike 1031 exchanges that require identifying and purchasing replacement property within 180 days, UPREITs provide tax deferral without any replacement property requirement.

Why This Matters:

• No pressure to find suitable replacement property in tight timeframes
• No risk of failed exchange due to inability to identify acceptable properties
• No transaction costs associated with purchasing replacement property
• No ongoing management responsibility for replacement property

Financial Example:

$8 million medical office building, $3 million basis:

• Taxable gain: $5 million
• Federal capital gains tax (23.8%): $1,190,000
• State tax (assume 5%): $250,000
• Total tax: $1,440,000

Via UPREIT: $0 tax at contribution. Full $8 million value converted to OP units generating income. Tax deferred until units sold—or eliminated entirely if held until death.

2. Professional Property Management

The Benefit: REIT assumes all property management responsibilities immediately upon contribution.

What This Means:

• No more tenant relations, lease negotiations, or rent collection
• REIT handles all maintenance, repairs, and capital improvements
• Professional leasing and asset management expertise
• Elimination of personal time commitment and management burden

For physicians approaching retirement or tired of property management responsibilities, this is often the single most valuable benefit.

3. Instant Portfolio Diversification

The Advantage: Rather than having wealth concentrated in a single property, OP unit holders participate in the entire REIT portfolio.

Diversification Benefits:

• Geographic: Exposure to properties across multiple states and markets rather than single location
• Property Type: Diversification across multiple medical office buildings, outpatient facilities, potentially other healthcare real estate
• Tenant: Hundreds of healthcare tenants instead of dependence on single practice or handful of tenants
• Risk Mitigation: Single tenant bankruptcy, local market decline, or property-specific issues don't devastate value

4. Predictable Quarterly Income

Income Structure: OP units generate quarterly cash distributions similar to REIT dividends, typically 4-6% annually.

Example:

$8 million in OP units at 5% distribution rate = $400,000 annual income ($100,000 quarterly)

Advantages Over Direct Property Ownership:

• More predictable than rental income from single property (no vacancy disruption)
• No unexpected capital expenditures reducing cash flow
• Professional management optimizes NOI across portfolio
• Distributions continue even if contributed property experiences challenges

5. Liquidity Options After Lock-Up Period

The Structure: Most UPREITs include 12-month lock-up period during which OP units cannot be exchanged for REIT shares or sold. After lock-up, unit holders gain liquidity options.

Post-Lock-Up Options:

Exchange for Publicly-Traded REIT Shares:

• OP units can be exchanged 1:1 for REIT shares (taxable event)
• REIT shares trade on major exchanges (NYSE, NASDAQ)
• Can sell shares immediately for cash or hold for continued income
• Provides liquidity without selling underlying real estate

Partial Liquidation:

• Can exchange/sell portion of units while retaining remainder
• Allows accessing some capital while maintaining tax deferral on balance
• Flexibility to liquidate as cash needs arise over time

6. Estate Planning Benefits

Basis Step-Up at Death: Perhaps the most powerful UPREIT benefit for estate planning:

• If OP units are held until death, heirs receive units at stepped-up basis equal to fair market value at death
• All deferred capital gains are eliminated—never taxed
• Heirs can immediately sell units or exchange for REIT shares without tax

Example:

• Physician contributes $8M property with $3M basis, receiving OP units
• 10 years later, OP units worth $11M when physician passes away
• Heirs receive units at $11M stepped-up basis
• Can immediately liquidate with zero capital gains tax
• Result: $5M of original deferred gain + $3M of appreciation = $8M gain avoided via step-up

For physicians in 60s-70s with substantial estates, this strategy can save millions in taxes.

7. Continued Real Estate Exposure

The Benefit: Physicians who believe in long-term healthcare real estate fundamentals can maintain exposure without direct ownership burdens.

Appreciation Potential:

• OP units appreciate as REIT's portfolio value increases
• Benefit from professional acquisition strategies and value-add initiatives
• Participate in portfolio diversification and growth
• Professional management typically generates better returns than individual property ownership

UPREIT vs. 1031 Exchange: Comparison

Factor	1031 Exchange	UPREIT
Tax Deferral	Complete deferral	Complete deferral
Replacement Property Required	Yes - must identify within 45 days, close within 180 days	No
Management Responsibility	Continue managing replacement property	Professional REIT management
Diversification	Single replacement property (or limited group)	Entire REIT portfolio (hundreds of properties)
Liquidity	Illiquid - must sell property to access capital	Can exchange for tradable shares after lock-up
Step-Up at Death	Yes	Yes
Transaction Complexity	High - two transactions (sale + purchase)	Moderate - single contribution
Exchange Risk	Can fail if replacement not identified/closed	No exchange risk
Best For	Physicians wanting continued direct property ownership	Physicians wanting to exit management while deferring taxes

When UPREITs Make Sense

UPREIT transactions are ideal for physicians in specific situations:

Approaching Retirement

Physicians in late 50s through 70s who want to:

• Eliminate property management burden
• Generate predictable retirement income
• Defer taxes while maintaining real estate exposure
• Potentially pass OP units to heirs with step-up in basis

Substantial Appreciated Value

Properties with large built-in gains where capital gains tax would be substantial:

• Purchased decades ago at much lower values
• Significant depreciation taken (depreciation recapture adds to tax burden)
• Properties where tax liability exceeds $500,000+

Property Management Fatigue

Physicians tired of landlord responsibilities:

• Tenant relations and lease negotiations
• Maintenance coordination and capital expenditure decisions
• Late-night emergency calls
• Time commitment detracting from practice or retirement enjoyment

Desire for Diversification

Physicians with significant wealth concentrated in single property:

• Concerned about single-tenant or single-property risk
• Want geographic and tenant diversification
• Believe professionally-managed REIT will outperform individual property ownership

Estate Planning Focus

Physicians prioritizing wealth transfer to heirs:

• Want to maximize value passed to children via basis step-up
• Prefer liquid assets (REIT shares) over illiquid property for heirs
• Want to simplify estate administration (REIT units easier to distribute than property)

Considerations and Potential Drawbacks

While UPREITs offer substantial benefits, they're not optimal for everyone:

Loss of Direct Control

OP unit holders have no control over:

• Property management decisions
• Capital expenditure timing and amounts
• Lease negotiations or tenant selection
• Whether/when property is sold

Physicians who want to maintain control should consider 1031 exchange or continued ownership.

Limited REIT Options

Not all REITs offer UPREIT transactions:

• Primarily larger, publicly-traded healthcare REITs
• Must find REIT interested in acquiring your specific property
• Property must meet REIT's acquisition criteria (size, quality, location)
• Smaller or lower-quality properties may not qualify

Lock-Up Period

Most UPREITs include 12-month restriction on exchanging units for shares:

• Cannot access liquidity during lock-up
• Exposed to REIT share price fluctuation during period
• If urgent cash needs arise, limited options during lock-up

REIT Performance Risk

OP unit value tied to REIT's overall performance:

• If REIT underperforms or share price declines, OP unit value falls
• Different from direct property ownership where you control value drivers
• Subject to broader market and REIT sector volatility

Distribution Rates May Vary

REIT distributions can change based on portfolio performance:

• Not guaranteed like bond interest
• REITs may reduce distributions during downturns
• Less predictable than rental income from stable, fully-leased property

The UPREIT Process: What to Expect

Step 1: REIT Identification (2-4 weeks)

• Healthcare real estate advisor identifies REITs with UPREIT programs
• Advisor approaches REITs on physician's behalf
• REITs indicate interest and preliminary valuation range

Step 2: Property Due Diligence (4-8 weeks)

• REIT conducts comprehensive property diligence
• Independent appraisal establishes value
• Environmental assessment, property condition report, title review
• Tenant lease and financial review

Step 3: Negotiation and Documentation (4-6 weeks)

• Finalize valuation and number of OP units to be issued
• Negotiate partnership agreement terms
• Tax advisors structure contribution for optimal treatment
• Legal documentation of contribution and OP unit issuance

Step 4: Closing (1-2 weeks)

• Property contributed to operating partnership
• OP units issued to physician
• No cash changes hands (unless physician receives some cash boot)
• REIT assumes property management immediately

Total Timeline: 3-5 months from initial REIT contact to closing

Tax Considerations

Contribution is Tax-Free (Generally)

Under IRC Section 721, contribution of property to partnership in exchange for partnership interest is non-taxable. Physician's basis in property carries over to OP units.

Distributions Are Taxable

Quarterly distributions received are taxable as ordinary income (similar to REIT dividends). Portion may be characterized as return of capital (non-taxable) depending on REIT's operations.

Exchange/Sale Triggers Tax

When OP units are exchanged for REIT shares or sold, deferred capital gains become taxable. Tax is calculated on difference between value received and physician's original basis (carried over from property).

Step-Up at Death

If OP units held until death, heirs receive units at stepped-up basis equal to fair market value at death, eliminating all deferred gain.

Finding the Right REIT Partner

Not all REITs offering UPREIT transactions are equal. Key factors to evaluate:

REIT Quality and Track Record

• Years in operation and market reputation
• Portfolio quality and geographic diversification
• Historical distribution rates and consistency
• Share price performance over time
• Management team experience and stability

Property Valuation Approach

• How aggressive or conservative is REIT's valuation methodology?
• Comparison to independent appraisals and market comparables
• Track record on fair dealing with contributing property owners

UPREIT Terms

• Lock-up period length (12 months is standard, some longer)
• Exchange ratio (OP units to REIT shares)
• Distribution rate and payment schedule
• Any restrictions on unit transfers or sales

Conclusion: A Powerful Strategy for the Right Situation

UPREIT transactions offer physicians a unique combination of benefits: complete tax deferral without replacement property requirements, professional management, portfolio diversification, predictable income, and powerful estate planning advantages through basis step-up.

For physicians approaching retirement who want to eliminate property management burdens while deferring substantial capital gains taxes, UPREITs often represent the optimal exit strategy—superior to both outright sales (immediate tax hit) and 1031 exchanges (continued management responsibility).

However, UPREITs require giving up direct control and accepting exposure to REIT performance. They work best for physicians comfortable with passive real estate investment who prioritize tax efficiency, income generation, and simplified wealth management over direct property control.

If your medical office building has appreciated significantly, you're tired of property management, and you want tax-efficient liquidity with continued real estate exposure, a UPREIT transaction deserves serious consideration as part of your exit planning strategy.